Audit’s Cautious Watchdogs

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J. Michael Cook, audit committee chair for a pair of giant companies, spent two mornings in a row last week going over the year-end close and financial release for one of them. First, he talked by phone with two audit-firm partners, then with the CFO.

The call to the audit partners — “to make sure we were in sync about it all” — probably wouldn’t have taken place in the time before the Sarbanes-Oxley Act, he says. Then, management handled such communications. “Now, though, it’s a normal part of the process.”

Indeed, the last five years have created a brand new normalcy for audit committees, once seen as a uniformly inert component of the governance system. Generally, the panels get high marks for how they’ve stepped in where the CEO once ruled: maintaining the relationship with the auditor. But not always.

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A survey that represented the first half of a corporate governance study by Boston College and Northeastern University accounting professors — titled Auditor Experiences of Corporate Governance in the Post Sarbanes-Oxley Era”” — found that while audit committees no longer play the “passive, ritualistic role” they had pre-2002, many hadn’t gotten the message when it comes to key roles like dispute resolution and appointing and dismissing the audit firm. At a large number of companies, management is still “the driving force” in those areas.”

It’s natural for the CEO to only grudgingly cede that responsibility to the audit committee, says Jeffrey Cohen of BC, one of the professors who authored the study. “The auditor really likes to resolve problems with management, rather than dealing with the audit committee,” he says. “In my opinion, it’s because the audit requires a lot of information from management, and the better you can resolve things with management, the better the relationship will be in the future.”

Saying One Thing, Doing Another

Cook, the former Deloitte & Touche CEO whose heads Eli Lilly’s and Comcast’s audit committees, agrees that some other companies have been resistant to giving more of that power to the board. “It has to do with financial management and their confidence,” he says. Fearing a loss of control, some managers have told the audit committee it was in charge, “then gone back to their office and said to the auditor, ‘You work for us; we don’t want you going right to the audit committee.'” But the companies he serves — he’s also on the board at International Flavors & Fragrances — are among the vast majority that he believes have adapted well to having a stronger audit panel.

Since Sarbanes-Oxley, “it’s much clearer today that there’s a three-legged stool formed by the audit committee, the auditor, and management,” he says. (At some companies, he notes, internal audit adds a fourth leg that can be equally effective.) “The legs have to be about the same length, or the stool will tumble over. There has to be a good relationship among the parties.”

Before, the auditors “were not connected side-by-side with the audit committee,” as he sees it. They dealt with the committee through corporate management. So that means that, from company to company, the degree of change can be “subtle,” as he views it.

These managements argue: “The auditors need a full relationship with the audit committee, but don’t leave us out.” Still, “in some instances, from what I’ve heard it’s gone too far, and the audit committee leg of the stool has gotten too important,” with management not having enough say.

The Committee of Last Resort

Not to worry, suggests Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. Audit committees have gained a much stronger hand in general these days, he says. “And many more committees have been willing to put the audit out for bids, to deliver more for the company.”

The big limitation to such bidding, he adds, is that “you’ve got four firms,” after the contraction of the old Big 8 in recent years. “But the old relationships, where once you had an auditor in place, it was there forever [because of close ties to management], that’s not true anymore.”

What’s taken its place — Mike Cook calls it the three-legged stool — is still searching for the right balance in such areas as dispute resolution and the hiring and firing of auditors. “I think it’s quite important that, just because Sarbanes-Oxley says the audit committee hires and fires, it doesn’t say anywhere that you leave out the CFO,” he asserts.

For most disputes, “my view is that the audit committee ought to be a court of last resort,” according to Cook. “If they have a legitimate, unresolvable difference of opinion, then the audit committee ought to get involved. But there aren’t too many committees that have the independent capability” to deal with the collision of opinions. And sometimes, “you must look to outside experts” for an answer. What he doesn’t want, early in a dispute, is for the company to say: “We’ll get Cook to resolve that for us.” He adds, “I doubt that I would have the expertise, if they can’t find it on their own.”

The need to work together applies as well when partners within the same audit firm are rotated at a client. “It should be the responsibility of the auditing firm to make sure you have the right people; don’t give a choice of 10 to the company,” says Cook. “Financial management must be involved in interviewing them. I certainly can’t see that decision being made by the audit committee.”

Cost, and Other Reasons to Switch

While Cook himself has never been on a board during an auditor switch, he can easily list some reasons it might make sense. “Cost to me would be one, and many of the rotations that have taken place have been cost-driven,” he says. The impetus often has been “the added costs of Sarbanes-Oxley — and they were substantial, although they’ve come down some.”

The act has “caused a lot of people to pay more attention to the cost of that audit relationship than they paid previously,” with “a number of companies challenging whether they have the need for the big-sized firm.” It may be “nice to have the Good Housekeeping Seal of Approval” of a big firm, he says, but “some companies may realize that they’re not that complex. The word they use is right-size.”

In Cook’s view of legitimate reasons to switch: “Cost is number two, number one is competence — experience, depth, resources, and quality of the team. You find in most instances that the team that is serving [a company] is professionally competent. If that’s wrong, a change needs to be made, and that doesn’t have anything to do with cost.”

Independent of the audit-cost question, Cook and others believe that the financial-expertise element of board composition needs work at many companies, so that the audit committee can fulfill its proper role. Two relatively untapped pools of finance talent, says Cohen of BC, are “retired audit partners and academics who specialize in auditing.”

Some companies with especially demanding boards have found that finding a skilled CFO or other finance expert is difficult. “Frankly, CFOs may be too busy doing their own jobs, and it’s not worth it to them” to take a job on another company’s board, especially at today’s going rates. “It’s a funny conundrum,” the professor adds. “You want to have a strong audit committee, but in order to attract them you must pay more.”

Professors, Cohen notes, likely would be delighted with today’s board-member pay. A problem, though, might be that companies see professors “as a bit more skeptical” than might be desirable from the corporate viewpoint.

“I tend to think it’s not sufficient today,” says Cook of the finance skill level on boards in general. And part of the problem is that terrific finance voices may be more suited to the audit committee alone, than to doing the broader work required of a full board member.

“If I were the chairman of a board,” he says, “I would give up one of 10 seats to that specialized finance expertise.” And skilled professionals would get serious consideration.